The software business can be a lucrative one, with high profit margins and a long runway for growth as satisfied customers sign up for additional services over time. But these characteristics also mean the industry is competitive, attracting rivals seeking to establish themselves in those prime market-share positions.
The challenge for investors is finding software specialists that have the right mix of sustainable growth and earnings power. Ideally, these stocks will be valued relatively cheaply, too.
With those goals in mind, let's look at two attractive software stocks to put on your watch list. Read on for good reasons to buy Microsoft (MSFT 1.82%) and Adobe (ADBE 0.87%).
1. Microsoft: Doing fine
In late July, Microsoft reported sales growth trends for its fiscal fourth quarter that disappointed some on Wall Street. Shares fell immediately following the announcement, yet the software giant turned in an excellent performance.
Although its PC division shrank as demand remains weak following the pandemic spike, Microsoft's cloud services expanded at a healthy clip.
Several of its main products, including Azure, grew at over 20% through late June. These wins offset sluggishness in areas like consumer tech and video games to push overall revenue up 10% in the period.
"We delivered a solid close to the fiscal year driven by Microsoft Cloud," chief financial officer Amy Hood said in a press release.
Microsoft's finances are even more impressive. Operating profit grew 18% to $24 billion this past quarter, translating into a whopping 43% margin. The company was able to easily afford sending $10 billion to shareholders through dividends and stock buybacks.
Look for these factors to drive positive results in your portfolio in the years to come.
2. Adobe: Delivering growth
If you think digital media production is an exciting growth industry, then Adobe could be just the stock for you. The company recently beat management's quarterly sales forecast as revenue expanded 13% after accounting for swings in currency exchange rates.
Operating cash flow was stellar for this software-as-a-service specialist, with revenue landing at $4.82 billion and cash flow reaching $2.14 billion.
An Adobe share purchase delivers many of the assets that growth stock investors are seeking, such as a dominant market position, economies of scale, and high customer loyalty. Like Microsoft, its business stands to benefit significantly from innovative AI capabilities, which are just starting to make their way into the company's products like Photoshop and Premiere Pro.
As you might expect, investors must pay a premium to own successful, cash-rich software companies like Microsoft and Adobe. The latter's shares are valued at 13 times annual sales today, and Microsoft isn't much cheaper at 12 times revenue. These price-to-sales ratios are below the highs that investors saw during the pandemic, though, even if they've expanded during the 2023 stock market rally.
In any case, investors could see solid returns from holding these companies for many years, and that long time horizon means you can risk paying a bit of a premium for them. In five or 10 years, you'll likely be glad that you put Microsoft and Adobe into your portfolio at today's prices.
